In the wake of the credit crunch, the Federal Reserve Bank (the Fed) reduced interest rates to virtually zero in December 2008 and embarked on a huge round of quantitative easing over the following 15 months, ending in March 2010. This involved the purchase of some $1.7 trillion of assets, mainly government bonds and mortgage-backed securities. There was also a large planned fiscal stimulus, with President Obama announcing a package of government expenditure increases and tax cuts worth $787 billion in January 2009.
By late 2009, the US economy was recovering and real GDP growth in the final quarter of 2009 was 5.0% (at an annual rate). However, the fiscal stimulus turned out not to be as much as was planned (see and also) and the increased money supply from quantitative easing was not having sufficient effect on aggregate demand. By the second quarter of 2010 annual growth had slowed to 1.7% and there were growing fears of a double-dip recession. What was to be done?
The solution adopted by the Fed was to embark on a second round of quantitative easing – or “QE2”, as it has been dubbed. This will involve purchasing an additional $600 billion of US government bonds by the end of quarter 2 2011, at a rate of around $75 billion per month.
But will it work to stimulate the US economy? What will be the knock-on effects on exchange rates and on other countries? And what will be the effects on prices: commodity prices, stock market prices and prices generally? The following articles look at the issues. They also look at reactions around the world. So far it looks as if other countries will not follow with their own quantitative easing. For example, the Bank of England announced on 4 November that it would not engage in any further quantitative easing. It seems, then, that the USA is the only one on board the QE2.
Articles
QE2 – What is the Fed Doing? Will it Work? Kansas City Star, William B. Greiner (5/11/10)
The ‘Wall Of Money’: A guide to QE2 BBC News blogs: Idle Scrawl, Paul Mason (2/11/10)
Federal Reserve to pump $600bn into US economy BBC News (4/11/10)
Beggar my neighbour – or merely browbeat him? BBC News blogs: Stephanomics, Stephanie Flanders (4/11/10)
Too much cash, bubbles and hot potatoes Financial Times (5/11/10)
Bernanke Invokes Friedman’s Inflation-Fighting Legacy to Defend Stimulus Bloomberg, Scott Lanman and Steve Matthews (7/11/10)
The QE backlash The Economist (5/11/10)
Former Fed Chairman Volcker says bond buying plan won’t do much to boost US economy Chicago Tribune, Kelly Olsen (5/11/10)
Ben Bernanke’s QE2 is misguided Guardian, Chris Payne (6/11/10)
Effects on commodity prices and stock markets
Gold hits record high, oil rallies on Fed stimulus Taipei Times (7/11/10)
Analysis: Fed’s QE2 raises alarm of commodity bubble Reuters, Barbara Lewis and Nick Trevethan (5/11/10)
Fed’s Bernanke defends new economic recovery plan BBC News (7/11/10)
Sit back and enjoy the ride that QE2 has set in motion Financial Times, Neil Hume (5/11/10)
US accused of forcing up world food prices Guardian, Phillip Inman (5/11/10)
Effects on other countries
The rest of the world goes West when America prints more money Telegraph, Liam Halligan (6/11/10)
Backlash against Fed’s $600bn easing Financial Times, Alan Beattie, Kevin Brown and Jennifer Hughes (4/11/10)
China, Germany and South Africa criticise US stimulus BBC News (5/11/10)
G20 beset with fresh crisis over currency International Business Times, Nagesh Narayana (5/11/10)
European Central Bank Keeps Rates at Record Lows New York Times, Julia Werdigier and Jack Ewing (4/11/10)
Official statements by central banks
FOMC press release Board of Governors of the Federal Reserve System (3/11/10)
News release: Bank of England Maintains Bank Rate at 0.5% and the Size of the Asset Purchase Programme at £200 Billion Bank of England (4/11/10)
ECB Press Conference ECB, Jean-Claude Trichet, President of the ECB, Vítor Constâncio, Vice-President of the ECB (4/11/10)
Questions
- How has the Fed justified the additional $600 billion of quantitative easing?
- What will determine the size of the effect of this quantitative easing on US aggregate demand?
- How will QE2 influence the exchange rate of the dollar?
- Why have other countries been critical of the effects of the US policy?
- What will be the effect of the policy on commodity prices?
GDP (or Gross Domestic Product) measures the value of output produced within a country over a 12-month period. It is this figure which we use to see how much the economy is growing (or shrinking). We can also look at how much different sectors contribute towards this figure. Over the past few decades, there has been a significant change in the output of different sectors, as a percentage of GDP, within the UK economy. In particular, the contribution of manufacturing has diminished, while services have grown rapidly.
However, there is one specific area that is making a growing contribution towards UK GDP and is expected to see acceleration in its growth rate by some 10% annually over the next few years: the internet. Although the internet is not an economic sector, the Boston Consulting Group (BCG) said that if it was, it would be the UK’s fifth largest sector and according to a report by Google, it is worth approximately £100 billion per year to the UK economy. Furthermore, it is an area in which the UK is one of the leading exporters. The emergence of the internet has transformed industries and individual businesses and the trend looks set to continue. The report by Google found that some 31 million adults bought goods and services online over the past year, spending some £50 billion.
What are the benefits for businesses of internet shopping and does it have an impact on the retail outlets on Britain’s highstreets? The answer is undoubtedly yes, but is it good or bad? What does the emergence of this new ‘sector’ mean for the UK economy?
Articles
UK net economy ‘worth billions’ BBC News (28/10/10)
UK’s internet industry worth £100 billion report Guardian, James Robinson (28/10/10)
’Nation of internet shopkeepers’ pumps £100 billion into economy Independent, Nick Clark (28/10/10)
UK internet is now worth £100bn to UK economy Telegraph, Rupert Neate (28/10/10)
Google at 10 BBC News, Success Story, Tim Weber (4/9/08)
Britain’s £100bn internet economy leads the world in online shopping Guardian, James Robinson (28/10/10)
Report
How the internet is transforming the UK economy The Boston Consulting Group October 2010
Government Statistics
United Kingdom: National Accounts, The Blue Book 2009 Office for National Statistics 2009 edition
Questions
- What is the UK’s GDP? How does it compare with other countries and how has it changed over the past 10 years?
- How does internet provision contribute towards growth? Think about the AD curve. Illustrate this on a diagram and explain the effect on the main macroeconomic objectives.
- Is there a problem with becoming too dependent on this emerging sector?
- How has the internet and online environment helped businesses? Think about the impact on costs and revenue and hence profits.
- What explanation is there for the change in the structure of the UK economy that we have seen over the past few decades.
- Will internet shopping ever replace the ‘normal’ method of shopping? Explain your answer.
Now the details of the Comprehensive Spending Review (CSR) are known, the comments are coming thick and fast. As we saw in the last news blog, Taking sides in the war of the cuts, economists are divided over whether the cuts will be compensated by a rise in private expenditure or whether overall aggregate demand will fall, driving the economy back into recession. As you will see in the articles below, they are still as divided as ever.
At least we know the details of the cuts. The plan is for an average cut across government departments of some 19 per cent over four years, although the size will vary enormously from department to department. The government is predicting that the effect will be about 490,000 fewer jobs in the public sector. In addition to the cuts, the retirement age is to rise to 66 for both men and women by 2020 and regulated rail fares will rise by 3% above RPI inflation for three years from 2012.
Examine the details of the measures in the articles below and consider what the effects are likely to be, both on the macro economy and on income distribution.
Articles
Spending Review: Osborne wields axe BBC News (20/10/10)
Spending Review: Q&A – what does it mean? BBC News (20/10/10)
Main points from the Comprehensive Spending Review Independent (20/10/10)
Osborne swings the welfare axe Independent, Oliver Wright (20/10/10)
Chancellor spells out austerity gamble Financial Times (20/10/10)
Easier said than done The Economist (20/10/10)
Julian Callow Sees Consolidation in Europe Bloomberg Podcasts, Tom Keene interviews Julian Callow, chief European economist at Barclays Capital (21/10/10)
Spending Review 2010: Business leaders urge clearer strategy for growth Telegraph, Louise Armitstead (20/10/10)
Spending Review 2010: George Osborne leaves markets unmoved Telegraph (20/10/10)
Spending review: Osborne gambles with the economy Guardian, Larry Elliott (20/10/10)
Larry Elliott on George Osborne’s spending review Guardian video (20/10/10)
Spending review: What the economists think Guardian (20/10/10)
Spending review: The work of a gambler Guardian editorial (20/10/10)
Spending review: economists and other experts respond Guardian, various economists (20/10/10)
Comprehensive spending review: We deserve an explanation. This wasn’t it Guardian, Aditya Chakrabortty (20/10/10)
Spending review: the winners and losers Guardian, Sam Jones (20/10/10)
All in it together? BBC News blogs, Stephanomics, Stephanie Flanders (20/10/10)
The sack: Lessons for government BBC News blogs, Peston’s Picks, Robert Peston (20/10/10)
A gamble on the economics Financial Times, Philip Stephens (20/10/10)
Q&A: the devil in the details Financial Times, Chris Giles (20/10/10)
Spending Review: Poorest Take Biggest Hit Sky News, Miranda Richardson (20/10/10)
Spending Review 2010: ‘More cuts could be needed’ Telegraph, Andy Bloxham (21/10/10)
Cuts ‘will push UK close to recession’ BBC Today Programme, Martin Wolf and Ken Rogoff (21/10/10)
Spending review cuts ‘are regressive’ BBC Today Programme, Tim Harford (21/10/10)
Spending review is a full stop but history lesson is vital in economics Guardian, Larry Elliott (25/10/10)
The Spending Review document
Spending Review 2010 HM Treasury (20/10/10)
Link to HM Treasury Spending Review site
Briefing and analysis from the Institute for Fiscal Studies
Opening remarks IFS, Carl Emmerson (21/10/10)
Link to briefing presentations (PowerPoint) IFS (21/10/10)
Analysis of fiscal consolidation by the IMF
Will It Hurt? Macroeconomic Effects of Fiscal Consolidation World Economic Outlook, Chapter 3, IMF (Oct 2010)
Questions
- What is the distribution of cuts between government departments?
- To what extent can it be said that there will be a real increase in health expenditure?
- What will be the effect of the cuts and tax increases on the distribution of income?
- What will determine whether the effect of the cuts will be to stimulate or dampen economic growth (or even drive the economy back into recession)? Which do you think is most likely and on what do you base your judgement?
- Trace through the multiplier effects of the measures.
- If the effect of the cuts is to drive the economy back into recession, what should the government’s ‘Plan B’ be?
In the run-up to the Comprehensive Spending Review a battle is raging. On one side are those who argue that cuts are necessary to secure long-term growth and to maintain confidence on the UK economy. These people include leaders of 35 major companies in the UK who wrote a letter to the Telegraph (see below) suppporting George Osborne’s policy of cuts.
On the other side are those who maintain that the cuts will drive the economy back into recession or, at least, will hamper economic recovery. The Federation of Small Businesses warns that “Some small firms rely on public-sector contracts for 50 or 60 per cent of their turnover. If the cuts are swingeing and overnight, these companies will be lost to the UK economy forever.”
Read the following articles to get a clear understanding of the arguments on both sides. Hopefully this will then put you in a better position to assess the cuts and their impact.
Articles
Osborne’s cuts will strengthen Britain’s economy by allowing the private sector to generate more jobs Telegraph, letter from 35 business leaders (18/10/10)
Spending Review 2010: cut now or pay later, say business leaders Telegraph, Andrew Porter, and Robert Winnett (17/10/10)
35 business leaders back Osborne’s cuts BBC News blogs: Peston’s Picks, Robert Peston (17/10/10)
Prominent Tory donors among business leaders who backed Osborne’s cuts Independent, Andrew Grice (19/10/10)
On the tight side The Economist (30/9/10)
History will see these cuts as one of the great acts of political folly Observer, Will Hutton (17/10/10)
Osborne has taken the coward’s route Guardian, David Blanchflower (18/10/10)
Osborne reading Christian Andersen, claims economist The Herald, Ian McConnell (19/10/10)
Time to broaden the debate on spending cuts Guardian, Ha-Joon Chang (19/10/10)
Slugging it out over spending cuts Independent, Sean O’Grady (19/10/10)
Spending Review 2010: We should all fear the darkness, David Cameron included Telegraph, Mary Riddell (18/10/10)
Spending cuts: Molehill and mountain BBC News blogs: Stephanomics, Stephanie Flanders (19/10/10)
Does fiscal austerity boost short-term growth? A new IMF paper thinks not The Economist (30/9/10)
Spending Review: Forecasts rely on ‘heroic assumptions’ BBC News (20/10/10)
Spending cuts: City divided on whether cuts are good for recovery Yorkshire Evening Post (20/10/10)
Spending Review 2010: Spending cuts will hit small businesses hardest Telegraph, James Hurley (20/10/10)
Speech
Rebalancing the Economy Speech by Mervyn King, Bank of England Governor (30/9/10)
Mervyn King warns of 1930s-style collapse (Extract from above speech) BBC News, Mervyn King (19/10/10)
Questions
- What are the main arguments for making large-scale cuts to government spending at the present time?
- What are the main arguments against making large-scale cuts to government spending at the present time?
- To what extent should the government’s poplicy on the size and timing of the cuts be influenced by international economic relations?
- What role might the ‘inventory cycle’ play in the economic recovery?
- Why may the government “pay heavily unless it learns to temper its bloody cuts with humanity”?
- How will large-scale spending cuts impact on (a) consumer confidence; (b) business confidence; (c) the confidence of international financiers?
- Will monetary policy allow fiscal policy to be tightened without causing a recession? Explain the effectiveness of monetary policy in these circumstances.
The growth in money supply is slowing. This is not surprising, given that the programme of quantitative easing, whereby the Bank of England injected an extra £200bn of (narrow) money into the banking system between March 2009 and February 2010, has come to an end.
Should we be worried about this? Has sufficient money been injected into the economy to sustain the recovery, especially as fiscal policy is about to be radically tightened (see the BBC’s Spending Review section of its website)? One person who thinks that the Bank of England should do more is Adam Posen, an external member of the Bank of England’s Monetary Policy Committee. In a speech on 28 September 2010, he argued that the UK was in danger of slipping into Japanese-style sluggish growth that could last many years. The reason is that capacity would be lost unless aggregate demand is increased sufficiently to bring the UK back up towards the potential level of output. Firms are unlikely to want to retain unused plant and equipment and underutilised skilled labour for very long. If they do start ‘disinvesting’ in this way, potential output will fall.
What, according to Adam Posen is the answer? With fiscal policy being tightened and with Bank rate as low as it can go, the only option is to increase money supply. But with CPI inflation at 3.1%, considerably above the target 2%, is there a danger that increasing the money supply will cause inflation to rise further? Not according to Posen, who sees inflation falling over the medium term.
Not surprisingly other economists and commentators disagree – including some of his colleagues on the MPC. The following articles look at the arguments on both sides. You will also find below a link to the speech and to money supply data. There is also a link to the latest Bank of England inflation and GDP forecasts.
Articles
Posen calls for QE to be resumed Financial Times, Chris Giles (28/9/10)
Weak lending data fuel debate on QE Financial Times, Norma Cohen (29/9/10)
Bank of England’s Adam Posen calls for more quantitative easing Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Posen pleads for new stimulus to save economy and democracy Independent, Sean O’Grady (29/9/10)
Bring back the usury laws Independent, Hamish McRae (29/9/10)
Rocking the boat on the MPC BBC News blogs, Stephanomics, Stephanie Flanders (28/9/10)
A Response to Adam Posen The Source, Alen Mattich (28/9/10)
Adam Posen is posing the Bank of England a tricky question Guardian, Nils Pratley (28/9/10)
UK economy: optimists vs. pessimists FT blogs, Chris Giles (29/9/10)
What should the Bank of England do next? BBC Today Programme, Stephanie Flanders and John Redwood (1/10/10)
Interest rates will rise, predicts former Bank of England deputy governor Guardian, Dan Milmo (4/10/10)
UK interest rates on hold at record low of 0.5% BBC News (7/10/10)
Speech
The Case for Doing More Speech to the Hull and Humber Chamber of Commerce, Industry and Shipping, Adam Posen (28/9/10)
Data
Money supply data
Money and Lending (Statistical Interactive Database) Bank of England
Bank of England Inflation and GDP forecasts
Inflation and GDP forecasts (Inflation Report) Bank of England
Questions
- Summarise Adam Posen’s arguments for a further round of quantitative easing.
- How may changes in aggregate demand affect a country’s potential (as well as actual) output?
- What are the similarities and differences between the UK now and Japan over the past two decades?
- Describe what has been happening to the various components of money supply over the past few months.
- What might suggest that the Bank of England was wrong in believing that the trend rate of growth was about 2.75%?
- What are the moral arguments about personal and state borrowing? Should we begin the ‘long retreat from the never-never society’?
- Analyse the arguments against a further round of quantitative easing.